Private Equity - Explained | What is Private Equity and what these firms actually do?

Private Equity - Explained

What is private equity?

 

What do private equity firms actually do?

 

Which are the different types of strategies they pursue and what is the typical structure of a private equity firm?

 

These are some of the questions we would try to answer in this article, but first things first why the name “private equity”?

 

Let's break it down, private because these are funds that are mainly interested in acquiring private companies that have not been listed on a stock exchange and equity because PE funds are exclusively focused on equity investments.

 

What about specialization? Can we say that certain PE funds prefer engaging with a specific type of target companies, the short answer is “yes” Most private equity firms specialize in deals with a specific type of targets based on the life cycle stage of these targets. Some PE’s are interested in young firms with high growth perspectives and a promising management team while others are focused on established companies with stable cash flows.

 

Leverage Buyout (LBO) transactions, in addition, it isn't rare to see Private equity investments in distressed companies. Actually distressed investments are one area of activity where there is some overlap between private equity and hedge funds. Both types of funds could invest in a distressed company, which is public. Hedge funds are unlikely to engage with a non-public firm.

 

The main difference however is their investment horizon, a private equity would typically try to:

 

1.      Acquire all the shares of the target

2.      Delist it

3.      Change management

4.      Introduce measures oriented towards improving financial performance

5.      And then be patient for at least a couple of years before exiting the investment through a sale or a new listing

6.      Duration is mostly more than two years

 

A hedge fund investment on the other hand would likely have a very short term duration, the fund would:

 

1.      Buy the securities of distressed companies when they believe that there is a good chance of reselling these securities and had a profit in the near term.

2.      Duration is not longer than two to three months.

 

This comparison provides a pretty good insight of what most private equity deals try to achieve. Following is just a summary of how does a private equity firms works.

 

1.      Acquire a large stake in a business preferably a hundred percent but not less than 50 percent.

2.      Position the business for growth through active involvement, advisory, and if necessary management rotations and substitutions

3.      Have the patience to grow the business.

4.      Improve its profitability

5.      And then Exit the investment in a five to ten year period.

 

Of course, the art of the private equity profession is to bet on the right companies and then successfully provide guidance in order to optimize their chances of being successful.

 

Great! let's talk about fund structure, there are two main ways in which private equity firms are typically structured

 

Limited partnership or a Closed-end fund

 

·       Limited partnerships are much more popular in the US while closed-end funds are prevalently used in Europe.

·       In a limited partnership we have two types of partners, general and limited. General partners are involved with the management of the fund target company's portfolio selection and post investment advisory. Limited partners role is to provide investment capital.

·       General partners charge the partnership a management fee and have the right to receive carried interest, this is the famous, 2 to 20 percent compensation structure, where 2% is paid as a management fee even if the fund isn't successful and then 20% of all proceeds after break-even are received by general partners.

·       In some cases a hurdle rate is added to the partnership agreement which defines a certain minimum rate of return that needs to be achieved before accruing carried interest to general partners.

·       Limited partners receive all of the funds proceeds minus what has been paid to general partners.

·       A closed-end fund is different, it has typically involves a newly created entity. Investors provide the required capital to that entity and the management firm signs a confidential management contract with the entity. Compensation schemes remain very similar under this type of structure, in most cases the classical 2-20 arrangement plus a hurdle rate for management. After which are accrued 20% of carried interest.

Very well the typical lifecycle of a PE fund looks in the following way:


·       A period allowing for the collection of investments in the fund, which can be as short as a couple of months and as long as two or three years.

·       Largely this depends on the reputation of the management firm and the demand for their services within the investment community. Established players in the industry have a significant edge. 

·       The next stage of a funds life is the investment period, which typically lasts up to five years. In this time, the general partners or management company depending on the type of fund structure chosen would search for suitable target companies fitting the funds strategy.

·       Once an investment has been successfully made it would be up to the fund managers to decide which is the best way to approach the business and optimize its performance.

·       Advice for the management panel and even management substitutions are very frequent to improve the governance when a private equity takes control.

·       Most PE firms are very hands-on throughout the entire lifecycle of the investment, they meet frequently with management and are keen on ensuring that the business is on the right track of being ready to be sold or listed on a stock exchange

·       Of course the final stage is “divestiture” and understandably it could last several years in some cases even five years.

·       Various factors are undertaken to determine when is the best time to exit the business.

·    A few examples our general state of the economy, market volatility, and quite importantly finding the right buyer, willing to pay the right price once the entire portfolio is divested

·   The fund closes and all proceeds are distributed among general and limited partners in a partnership structure or among investors and the management company in a closed-end fund

 

I hope this article allowed you to gain a good understanding of What is private equity? and What do private equity firms actually do?

 

So that’s it for today. Thanks for reading and do comment your email id below in the comment box, so that we can add you in our subscriber's list and you will be updated whenever we publish our next article.

 

Till then, Take care!

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